[OPE-L] Financing wars with inflation

From: Gerald_A_Levy@MSN.COM
Date: Thu Jan 13 2005 - 17:42:00 EST

The authors are rather vague on how the dynamics can be
expressed with "sets of coupled nonlinear equations."

In solidarity, Jerry

----- Original Message ----- 
From: pobox1429 
Cc: anti-Capitalism@yahoogroups.com 
Sent: Monday, January 10, 2005 7:33 AM
Subject: [A-C] Fw: Financing wars with inflation

      Financing wars with inflation

        Inflation is the economic situation in which prices apparently move monotonically upward and the value of money decreases. To classical economics, inflation is the undue increase in the supply of credit above the level that is supported by current savings. High inflation is always associated with high rates of money supply growth while the relationship is weak for countries with low inflation [2]. Thus, fighting high inflation requires reducing the growth rate of the money supply.

        Inflation is one of the few big issues in macroeconomics, together with unemployment, monetary policy, fiscal policy, import-export deficits, productivity, government spending and the business cycle, and has been at the forefront of public battles over the past half-century. A good economic policy should strive to achieve a balance between often contradictory requirements: for instance, many economists assume that unemployment tends toward a natural rate below which it cannot go without creating inflation. Samuelson and Solow had brought to the U.S. the empirical evidence, first compiled by the British economist A.W. Phillips, that there seems to be a trade-off between inflation and unemployment¨Cthat is, higher inflation meant lower unemployment.

        There is thus a long tradition among economists to adopt monetary policy as a way to keep the economy running on high-employment overdrive. Allowing prices to rise seemed the only humane thing to do. Friedman argued however that the unemployment/inflation tradeoff was temporary, and he also pointed out that using fiscal and monetary policy to avert recessions was a lot harder than it looked. The difficulties stem from the fact that policies designed to restrain inflation by lowering the level of aggregate demand will tend to depress investment and harm capacity. Improved industrial performance requires a climate conducive to investment and research and development, which in turn depends on, inter alia, high and stable levels of aggregate demand. Business and inflation cycles often result from the combination of endogenous interactions (that can lead to incoherence) and of the effects of institutions to contain these tendencies in the economy. The corresponding economic time series can exhibit smooth growth and well-behaved cycles as possible transitory results of the economic processes, but can also allow for intermittent conditions conducive to the emergence of incoherence or turbulence. Institutional factors attempt to act as circuit breakers on the economy. 

        Whenever institutionally determined values dominate endogenously determined values, the path of the economy is broken and an interactive process, which starts with new initial conditions, generates future values. Specifically, whenever the economy threatens to behave incoherently, these stabilizers, whether built-in or activated by government authority, prevent the economy from continuing on the prior determined path, with the corresponding added complication and possible elements of destabilization. These are important elements in the path evolution of inflation.

        In standard economic theory, inflation is associated with money supply growth. At equilibrium, money determines price level and implies equilibrium in markets for other assets. At equilibrium, money demand depends primarily on income and interest rates. But there are several factors keeping money demand unstable, such as financial innovations as well as expectations. Indeed, one of the major causes of the complexity in stabilizing inflation together with other macroeconomic variables is that expectations of producers, consumers and investors may play a key role in the dynamics. Indeed, investment allocations or inflation expectations are influenced by ex-ante values of the risk premia and ex-post returns are rough approximations of these. Thus, ¡°inflationary expectation¡± occurs when people begin to raise prices not because of actual changes in supply or demand or cost or the size of the money supply, but out of fear that some such changes might happen. In the 1990s, when Alan Greenspan, the chairman of the US federal reserve, said that the U.S. was still suffering from the inflationary expectations caused by the monetary excess of the 1970s, he was directly addressing the potential for inflation caused by ¡°inflationary expectations.¡± When European central banks added liquidity to the gold market in an attempt to prevent an increase in the price of gold from creating concerns about a decrease in the value of the dollar, they were addressing the psychological component of price stability involved in ¡°inflationary expectations.¡± 

        Mathematically, this dynamics translates into sets of coupled nonlinear equations expressing both the competition and delays between expectations and realizations and the presence of positive and negative feedback loops. The complexity of the resulting dynamics stems from the complex nonlinear negative and positive feedback processes intertwining the different component of policies.

        There are several causes of inflation. A prominent origin is wars, which cause the type of inflation that results from a rapid expansion of money and credit. For instance, in World War I, the American people were characteristically unwilling to finance the total war effort out of increased taxes. This had been true in the Civil War and was also so in World War II and the Vietnam War. Much of the expenditures in World War I, were financed out of the inflationary increases in the money supply. If money supply growth and real income are constant, then expected inflation rate equals current inflation rate (assuming no change in elasticities). This is more or less the standard situation most of the time, as nominal interest rates and inflation often move together. In contrast, if people expect an increase in money growth, this then would lead them to expect higher inflation. And expectation of higher inflation raises the inflation rate even if money growth does not actually increase.

        If inflation is perfectly anticipated, it entails no cost for creditors and debtors as nominal interest rates incorporate expected inflation and nominal wages adjust to offset price increases. But inflation devalues the currency and imposes ¡°shoe leather costs¡±, that are costs of efforts to minimize cash holding (for instance the time and effort in making lots of trips to ATM machines). Prices will be changed more frequently and this imposes ¡°menu costs,¡± which are the costs of changing prices.

        If inflation is unanticipated, it induces transfers of wealth from holders of nominal assets to holders of real assets [11]. Suppose for instance that your savings account pays 8% per year and that you expected 4% inflation but the realized inflation is 7%. You obtain a real interest rate of 1% instead of the 4% that you expected. You are worse off but the bank is better off. 

        Unanticipated inflation increases risk of gaining or losing wealth and requires more resources for forecasting inflation. Unanticipated inflation causes confusion about the relative price movements as it could affect some prices sooner than others. What if the price of oil increases relative to natural gas? Is that a change in relative prices, or a result of inflation? If the former holds, consumers should switch from oil to natural gas for heating. If the latter holds, and they switch, then resources are misallocated. More generally, informal accounts of infla- tion¡¯s effects are common, but there are few models which get to grips with the central e.ects. Partly as a result of this, and partly as a result of many econometric problems, much of the empirical evidence remains unconvincing (see [11] for an assessment of the various contributions). For all these reasons, a main target of central banks of developed countries in the last decade of the twentieth century has been a low inflation [3].

        As we have seen, inflation is first-of-all an indirect tax leveraged by governments through their (partial) control of the money supply to help them finance wars or other expenditures. The problem is that inflation is not easily controlled due to the dual effect of financial innovations and expectations. Once people start to expect an inflation regime, their expectations may lead to strong positive feedbacks that make inflation run away. There are several remarkable historical examples of such runaways, called ¡°hyperinflation,¡± such as those that occurred in Germany (1922-1923), Hungary (1945-1946), Latin America in the 1980s and Russia in the recent years. 

        Such hyperinflation phases are very costly to society, as there are enormous ¡°shoe-leather¡± costs, the workers have to be paid more frequently (even daily) and there are rushes to spend the currency before prices rise further. Hyperinflation reduces the real value of taxes collected, which are often set in nominal terms and by the time they are paid, real value has fallen. Hyperinflation leads to large disruptive effects on price and on wage changes and prevents distinguishing relative from aggregate price movements. Wealth allocation becomes very inefficient. Detecting hyperinflation in an early stage might contribute to avoid such tragedy.

        ¡ªD. Sornette, H. Takayasu, W.-X. Zhou, Finite-time singularity signature of hyperinflation

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